Arthur Hayes new article: The bull market will be delayed, and the Fed's policy shift may trigger a market change in September

Original Title: “Boom Times… Delayed”

Author: Arthur Hayes

Translation: Shen Chao TechFlow

(The views expressed in this article are solely those of the author and should not be considered as investment advice or a basis for investment decisions.)

Like the dog in Pavlov's classical conditioning experiment, we all believe that the correct response to interest rate cuts is to "buy the f***ing dip" (BTFD). This behavioral response stems from memories of low inflation during the Pax Americana era. *Whenever there is a threat of* deflation, it is bad news for holders of financial assets (i.e., the wealthy), and the Federal Reserve will decisively turn on the printing press. As the global reserve currency, the dollar creates a loose monetary environment for the world.

The global fiscal policy response to the COVID pandemic (or the scam you believe it to be) ended the era of deflation and ushered in an era of inflation. Central banks around the world were slow to acknowledge the inflationary impact of COVID-19, adjusting monetary and fiscal policies and raising interest rates. The global bond market, especially the U.S. bond market, believed in the central banks' determination to control inflation, thus not pushing yields to extremely high levels. However, the assumption that central banks will continue to meet the bond market's expectations by raising rates and reducing the money supply is highly uncertain in the current political environment.

I will focus on the U.S. Treasury market, as the dollar, being the global reserve currency, makes it the most important debt market in the world. Any debt instrument issued in any currency will be influenced by U.S. Treasury yields. Bond yields reflect the market's expectations for future economic growth and inflation. The ideal economic state is one of economic growth accompanied by low inflation, while a bad state is growth accompanied by high inflation.

The Federal Reserve has successfully convinced the Treasury market of its determination to fight inflation by raising policy rates at the fastest pace since the early 1980s. From March 2022 to July 2023, the Fed raised rates by at least 0.25% at every meeting. Even during this period, when the government released inflation indices reaching a 40-year high, the 10-year U.S. Treasury yield did not exceed 4%. The market believed that the Fed would continue to raise rates to curb inflation, hence long-term yields did not surge.

U.S. Consumer Price Index (white), 10-Year U.S. Treasury Yield (gold), and Federal Funds Rate Upper Bound (green)

However, everything changed at the Jackson Hole meeting in August 2023. Powell hinted that the Fed might pause interest rate hikes at the September meeting. Yet, the shadow of inflation still loomed over the market, primarily because increased government spending is a major driver of inflation, and there are no signs of this trend weakening.

Economists at MIT found that government spending is one of the main reasons driving up inflation.

On one hand, politicians know that high inflation will reduce their chances of re-election; but on the other hand, providing benefits to voters through currency devaluation can increase their chances of re-election. If they only distribute benefits to their supporters, funded by the savings of opponents and supporters alike, then politically, increasing government spending is advantageous. Thus, they find it hard to be voted out of office. This is precisely the strategy adopted by President Biden's administration.

In peacetime, overall government spending has reached historical highs. Of course, "peace" here is relative, referring only to the feelings of imperial citizens; for those who have lost their lives due to American weapons, recent years can hardly be called peaceful.

If these expenditures were funded by increased taxes, the situation would not be as severe. However, raising taxes is highly unpopular for incumbent politicians, so it has not happened.

In this fiscal context, at the Jackson Hole meeting on August 23, 2023, Fed Chair Powell announced that the Fed would pause interest rate hikes at the September meeting. The more the Fed raises rates, the higher the cost for the government to finance its deficit. By increasing the cost of deficit financing, the Fed can curb reckless spending. Spending is a major driver of inflation, which the Fed intended to suppress through rate hikes, but ultimately chose to pause, allowing the market to adjust itself.

After Powell's speech, the 10-year U.S. Treasury yield quickly rose from about 4.4% to 5%. This was surprising, as even when inflation reached 9% in 2022, the 10-year yield was only around 2%; yet 18 months later, with inflation dropping to about 3%, the yield approached 5%. Higher rates led to a 10% drop in the stock market and, more importantly, raised concerns about the potential collapse of U.S. regional banks due to losses in their Treasury investment portfolios. Faced with higher deficit financing costs, reduced capital gains tax revenue due to the stock market decline, and a potential banking crisis, "bad girl" Yellen intervened, providing dollar liquidity to stabilize the situation.

As I mentioned in my article Bad Gurl, Yellen stated that the U.S. Treasury would issue more Treasury bills (T-bills). This would shift funds from the Fed's reverse repurchase agreement (RRP) program to T-bills, re-leveraging the financial system. This announcement, made on November 1, 2024, fueled a bull market in stocks, bonds, and cryptocurrencies.

From late August 2023 to late October 2023, Bitcoin's price fluctuated significantly. However, with Yellen injecting liquidity, Bitcoin began to rise and reached an all-time high in March of this year.

Reverse Reflection

History does not repeat itself simply, but there are always similarities. In my previous article Sugar High, I failed to fully recognize this when discussing the impact of Powell's wage policy shift. Regarding the positive impact of the upcoming interest rate cuts on risk markets, I shared the same view as most, which made me somewhat uneasy. On my way to Seoul, I happened to check my Bloomberg watchlist, which recorded the daily changes in RRP. I noticed that RRP had risen, which puzzled me because I thought it would continue to decline due to the U.S. Treasury's net issuance of T-bills. Upon further investigation, I found that this increase began on August 23, the very day of Powell's policy shift. I also considered whether the surge in RRP could be attributed to quarter-end window dressing. Financial institutions typically deposit funds into RRP at the end of the quarter and withdraw them the following week. However, the third quarter does not end until September 30, so window dressing cannot explain this phenomenon.

Next, I considered whether money market funds (MMFs) chose to sell T-bills and deposit cash into RRP due to declining T-bill yields, in pursuit of higher short-term dollar returns. I created a chart showing the yields of 1-month (white), 3-month (yellow), and 6-month (green) T-bills. The vertical lines in the chart mark several key dates: the red line represents the days when the Bank of Japan raised rates, the blue line represents the days when the Bank of Japan announced it would not consider future rate hikes amid poor market reactions, and the purple line marks the day of the Jackson Hole speech.

Money market fund managers need to decide how to achieve the best returns on new deposits and maturing T-bills. The yield on RRP is 5.3%, and if T-bill yields are slightly higher, funds will flow into T-bills. Starting from mid-July, the yields on 3-month and 6-month T-bills fell below the yield on RRP. However, this was mainly due to the unwinding of carry trades prompted by market expectations of a stronger yen, leading to speculation that the Fed might ease policy. The yield on the 1-month T-bill still remained slightly above the yield on RRP, which is reasonable since the Fed has not clearly indicated it will cut rates in September. To validate my hypothesis, I plotted a chart of RRP balances.

Before Powell's speech at Jackson Hole on August 23, RRP balances were generally declining. During that speech, he announced that the Fed would cut rates in September (marked by the vertical white line in the chart). The Fed plans to lower the federal funds rate to at least 5.00% to 5.25% at the meeting on September 18. This validated the market's expectations for the movements of 3-month and 6-month T-bills, while the yield on the 1-month T-bill also began to narrow its gap with RRP. The yield on RRP will only decrease the day after the rate cut. Therefore, from now until September 18, RRP offers the highest returns among various yield instruments. As expected, after Powell's speech, RRP balances immediately rose as money market fund managers scrambled to maximize current and future interest income.

Although Bitcoin surged to $64,000 on the day of Powell's policy shift, its price has since fallen 10% over the past week. I believe that Bitcoin is the most sensitive indicator of dollar liquidity conditions. When RRP balances rose to about $120 billion, Bitcoin's price dropped. The increase in RRP caused funds to remain on the Fed's balance sheet, unable to be re-utilized in the global financial system.

Bitcoin's volatility is significant, so I admit I may be overanalyzing the price changes over a week. However, my interpretation of events aligns so closely with the actual observed price movements that it is hard to attribute it solely to random fluctuations. Validating my theory is actually quite simple. If the Fed does not cut rates before the September meeting, I expect T-bill yields to continue to remain below RRP. Therefore, RRP balances may continue to increase, while Bitcoin might hover around current levels, with the worst-case scenario being a slow decline to $50,000. Let's wait and see. My shift in market perspective has made me hesitant to hit the buy button. I have not sold any cryptocurrencies because I am pessimistic about the short-term market. As I will explain, my pessimism is only temporary.

Out-of-Control Fiscal Deficit

The Federal Reserve has taken no measures to control the main driver of inflation: government spending. The government is likely to reduce spending or raise taxes only when the cost of financing the deficit becomes too high. The Fed's so-called "restrictive policy" is merely talk, and its independence is just a nice story told to gullible economics disciples.

If the Fed does not tighten policy, the bond market will adjust itself. Just as the 10-year Treasury yield unexpectedly rose after the Fed paused rate hikes in 2023, the Fed's rate cuts in 2024 could push yields dangerously close to 5%.

Why is a 5% 10-year Treasury yield so dangerous for the "Pax Americana" fictitious financial system? Because this is precisely the threshold at which Yellen felt intervention and liquidity injection were necessary last year. She knows better than I do how fragile the banking system is when bond yields rise sharply; I can only speculate on the severity of the problem based on her actions.

She has trained me like a dog to expect a certain reaction to specific stimuli. A 5% 10-year Treasury yield will halt the bull market in stocks. It will also reignite concerns about the health of the balance sheets of non-"too big to fail" banks. Rising mortgage rates will reduce housing affordability, a significant issue for American voters in this election cycle. All of this could happen before the Fed cuts rates. In this scenario, considering Yellen's steadfast support for the Democratic "puppet candidate" Kamala Harris, the market could face severe shocks.

Clearly, Yellen will only stop once she has done everything in her power to ensure Kamala Harris is elected President of the United States. First, she may start to reduce the funds in the Treasury General Account (TGA). Yellen may even preemptively signal her intention to deplete the TGA so that the market can quickly react to her expectations and become more active! Next, she may instruct Powell to halt quantitative tightening (QT) or even potentially restart quantitative easing (QE). All these monetary maneuvers would be favorable for risk assets, especially Bitcoin. If the Fed continues to cut rates, the amount of money injected must be sufficient to offset the rising RRP balances.

Yellen must act swiftly, or the situation may worsen, leading to a full-blown crisis of confidence among voters in the U.S. economy. This would be detrimental to Harris's election prospects unless a miraculous batch of mail-in ballots is discovered. As Stalin might have said, "It's not the people who vote that count; it's the people who count the votes." Just kidding, don't take it seriously.

If this situation occurs, I expect market interventions to begin at the end of September. Before that, Bitcoin may continue to fluctuate, while altcoins may decline further.

I once publicly stated that the bull market would restart in September, but I have now changed my view; however, this does not affect my investment strategy. I remain firmly invested without using leverage. I will only increase my holdings in some quality altcoin projects that are more discounted relative to what I consider fair value. Once fiat liquidity is expected to increase, the tokens of those projects with users willing to pay actual fees for their products will surge.

For professional traders with monthly profit and loss targets or weekend investors using leverage, I apologize; my short-term market predictions are as unreliable as a coin toss. I tend to believe that those who control the system will ultimately resolve all issues through money printing. I write these articles to provide context for current financial and political events and to test whether my long-term assumptions still hold, hoping that one day my short-term predictions will be more accurate.